Educational Articles

Can You Build a Foundation for Your Portfolio With Infrastructure-Related Stocks?

Erik A. Antonson
| May 18, 2010

Rebuilding the deteriorating United States infrastructure, one of the least eyecatching issues being discussed on Capitol Hill, is of more necessity than anyone in Congress is willing to let on. In 2007, the I-35W Mississippi River Bridge collapsed, killing 13 and injuring scores more. Parts of New Orleans were wiped from the map and thousands died when Hurricane Katrina made landfall in 2005; much of the destruction was due to the catastrophic failure of the levee system. Granted, these are “worst-case” scenarios. However, the reality is that the nation’s highways and railways; stations and ports; and water and wastewater systems are all crumbling to one degree or another.

As pointed out by the above examples, ignoring these problems is endangering the public, threatening the United States’ economic prosparity, and, as many economists and news pundits have been quick to point out, resulting in missed job-creation opportunities at a time when the nation’s unemployment rate is hovering near 10%. On point, the American Recovery and Reinvestment Act of 2009 (ARRA), colloquially known as the stimulus plan, was signed into law by President Barack Obama in February, 2009. The package set aside roughly $81 billion (certainly nothing to sneeze at, but a proverbial drop in the bucket compared to what is really needed) for infrastructure investment, most of which was earmarked for the construction of “hard” infrastructure and government facilities and headed directly to construction, engineering, heavy equipment, and building materials companies. However, by the time it was passed, Wall Street was already betting big that ARRA would spark an economic recovery and raise corporate profits. Infrastructure-related stocks were some of the first to take off; shares of companies like AECOM Technology (ACM), Fluor (FLR), Sterling Construction (STRL), Martin Marietta Materials (MLM), Astec Industries (ASTE), and Caterpillar (CAT) all rose sharply in the months following the selloff that occurred in November, 2008. The prevailing wisdom was that the federal government would spend on things such as infrastructure to stave off a deeper recession and create jobs.

Of course, the aforementioned run did not last, and all of the infrastructure-related equities began falling back to earth when quarterly profit comparisons remained unfavorable. Investors quickly recognized that even though the federal government is spending about $81 billion on infrastructure-construction and -improvement projects, the money gets funneled through state and local municipalities. Unfortunately for engineering, building materials, machinery, and construction companies, most of the 50 states in the Union are in awful financial shape. In fact, not only were state and local governments reluctant to spend the money given to them by the federal government via ARRA, most were busy cutting public works programs and other infrastructure projects to make up for budget shortfalls. So, at present, fewer blueprints are being drawn up, a declining number contractors are being hired, roadbuilding and other heavy equipment orders are being put on hold, and less cement and aggregates are being shipped from kilns and quarries.

It was not long after investors realized that the 50 states are in control of infrastructure spending that Wall Street figured out that the stimulus money would lead to increased competition among the sectors’ top players, thereby erasing much of the profit that could be squeezed out of any given project. (This bit is only relevant when looking at the contractors and engineering companies.) Indeed, it did not take long for the firms in the Heavy Construction Industry to start bidding wars across the United States, pressuring already razor-thin operating and profit margins. Making matters worse, we surmise smaller (usually private) companies began submitted bids that only covered costs just to stay in business, which only happens when supply far exceeds demand.

So, now we are back at square one. Is there money to be made in domestic infrastructure-related stocks? Certainly. although, the nation’s infrastructure needs (including basic maintenance and repair) could easily be swept under the rug during these tough economic times. For example, the Senate and House of Representatives both failed to draft and pass a new U.S. transportation spending bill before the Safe, Accountable, Flexible, Efficient Transportation Equity Act: A Legacy for Users (the previous highway spending authorization) expired in September, 2009. Meanwhile, legislation that reformed healthcare in the United States was signed into law in March, 2010. We are not downplaying the significance of healthcare reform. We also understand that spending heavily on infrastructure-improvement projects would be a difficult sell at present, due to the federal government’s enormous debt burden. Still, the United States’ infrastructure needs are significant and need to be addressed eventually.

Given this backdrop, however, we think that engineering and construction-services companies with a global focus will generally outperform those that concentrate most of their resources on winning contracts on the home front in the near term. Moreover, many foreign governments, especially those in India and China, are spending feverishly on infrastructure projects to catch up to more developed countries. This raises the investment appeal of Fluor, URS (URS), KBR (KBR), Chicago Bridge & Iron (CBI), and Foster Wheeler (FWLT). We would leave most of the smaller domestic players, like Sterling Construction, AECOM Technology, and Layne Christensen (LAYN), alone for now, even though winning one or two big contracts could really boost their bottom lines materially. We feel there is just too much competition in North America right now, which has led to oversupply and shrinking profits. Moreover, most (some estimates put the figure above 90%) of construction-related companies in the United States are privately held (and, therefore, don’t trade on any exchange). Private companies are usually more willing to cut profits down to the bone, which bodes ill for investors in their publicly traded counterparts.

We can’t get too enthusiastic about most of the names in our Building Materials Industry, but like the long-term prospects of CEMEX (CX). Other cement and aggregate suppliers that stand out, again thanks to their large global footprints, are Lafarge and Holcim.

We also recommend passing on most heavy equipment makers, including Caterpillar and Deere & Co. (DE), for now. The shares of just about every one of these companies has rebounded convincingly since bottoming out late in 2008. Industry-wide profits have not recovered as quickly, however. Thus, P/E multiples are quite lofty relative to historical averages, and there is not much long-term potential in most cases. We do like the turnaround prospects of Terex (TEX) stock, though. Terex is one of the largest heavy machinery manufacturers in the world, but has recently fallen on hard times. We think it can turn a profit in the fourth quarter of 2010, and believe the bottom line will continue advancing from there. We also like Komatsu since it currently boasts the biggest share of the Chinese and the Middle Eastern marketplaces.

Finally, for those that tend to be more aggressive or are looking to invest in growth potential abroad there are products like INDXX China Infrastructure Index Fund that is being offered by Emerging Global Shares. It is an ETF that tracks an index of 30 Chinese companies that, in one way or another, are linked to either “hard” or “soft” infrastructure construction in that nation, and is one of the few ways for Americans to invest in Chinese infrastructure-related equities.